GEOPOLITICAL STRATEGY
SPECIAL REPORT
Edge
RESEARCH
DISCOVERY
ACTION
“Holy War” And Oil Prices
The interface of investment research
January 5, 2016
In this Issue:
FF
Saudi-Iranian geopolitical tensions are the main source of geopolitical risk in the
Middle East;
FF
But this has been true since 2011 – with the Syrian Civil War and rise of the Islamic
State as the undercards to the main event;
FF
The recent rise in tensions increases the probability that the proxy war between Saudi
Arabia and Iran will migrate to a geography that matters for oil markets, like Iraq;
FF
Sectarian tensions in Saudi Eastern Province and Bahrain are also more likely to catch
flame;
FF
However, competition between Saudi Arabia and Iran also ensures that OPEC remains
dysfunctional;
FF
And without OPEC to balance the market, fundamental supply and demand dynamics will
continue to weigh on oil prices until the market rebalances, likely by the end of 2016;
FF
We suggest going long a December 2016 WTI $50/$55 call spread – paying a net
premium of roughly $1.20/bbl – to capture the rising volatility and higher probability
of a right-tail risk event.
FF Saudi Insecurity
Explains (Nearly)
Everything In The
Middle East................3
FF “Saudi Arabia Will
Go It Alone”................5
FF Constraints And
Risks To Saudi
Assertiveness.............7
FF Investment
Conclusions.............10
Editorial Board
Marko Papic
Managing Editor
David Abramson
Managing Editor
S
audi Arabia has broken off diplomatic contact with Iran for the first time since 1988,
marking the lowest point in relations between the two Middle Eastern rivals this decade.
The decision follows the overrunning of the Saudi embassy in Tehran amid rioting prompted
by the Saudis’ provocative execution of outspoken Shia cleric Sheikh Nimr al-Nimr. That
relations should deteriorate so precipitously should come as no surprise. Rising Saudi
insecurity has been the main source of geopolitical risk in the Middle East since 2011.1
Martin Barnes
Managing Editor
Ian MacFarlane
Managing Editor
Jim Mylonas
Managing Editor
Chester Ntonifor
Editor/Strategist
Santiago E. Gomez
Editor/Strategist
David Boucher
Associate Editor
Matt Gertken
Associate Editor
Jesse Anak Kuri
Research Analyst
The tensions between Saudi Arabia and Iran are not primarily about the Sunni-Shia sectarian split. Rather, at the heart of the rivalry is the desire to fill the power vacuum left
over by the withdrawing U.S., which has reduced its footprint in the region to deal with
the broader challenges of global multipolarity.2 Sunni-Shia sectarian tensions are real, of
1
Please see BCA Geopolitical Strategy Special Report, “Riyadh’s Oil Gambit,” dated October 11, 2011, available at
gps.bcaresearch.com.
2
Please see BCA Geopolitical Strategy Strategic Outlook, “Strategic Outlook 2016: Multipolarity & Markets,” dated
December 9, 2015, available at gps.bcaresearch.com
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GEOPOLITICAL STRATEGY - SPECIAL REPORT JANUARY 5, 2016
course, but they are also subject to the interests
of nation states. Both the Saudis and Iranians
manipulate these passions to rally support for
their regimes at home and abroad – a strategy
that risks getting out of hand. The sectarianinflected power struggle between these states
supersedes any risks that the Islamic State
militants pose to energy markets.
CHART 1
The latest episode of the conflict will reinforce
three ongoing investment-relevant themes:
At the heart of
the rivalry is
the desire to
fill the power
vacuum left
over by the
withdrawing
U.S.
FF
Mn Bbl/
Day
Saudis Have Surged Production…
Mn Bbl/
Day
SAUDI ARABIA OIL PRODUCTION
10.25
10.25
10.00
10.00
9.75
9.75
9.50
Proxy wars shift geography: Tensions between Iran and Saudi Arabia have thus far
spilled over to largely investment-irrelevant
9.25
geographies like Syria and Yemen. This
may soon change, especially given the high
level of Saudi insecurity. Investors should
watch carefully for any evidence of Saudi
13
SOURCE: U.S. EIA
military operations in the Sunni areas of
Iraq, sectarian tensions in the Saudi Eastern Province, and any restart of social unrest in Bahrain.3
November 2014
OPEC meeting
9.50
9.25
© BCA Research 2016
14
15
16
FF
Deteriorating Saudi domestic stability: The Saudi decision to execute al-Nimr suggests a high level
of domestic risk that is difficult to quantify. In particular, it suggests that Saudi Arabia is trying
to bolster support for the ruling Sudairi branch of the Saud royal family, whose near-monopoly
of power today stands in contrast to the consensus-building rule of previous Saudi monarchs.4
FF
OPEC is paralyzed: With tensions between the two OPEC heavyweights growing, it is unlikely
that the organization will re-emerge as a functioning cartel.5 For example, Saudi Arabia will
not deviate from the current strategy of protecting its crude oil market share, which it initiated
following the fateful November 2014 OPEC meeting. Since that date, Saudi oil production has
gone up 4.2%, or 0.4 million bbl/d (Chart 1), and oil prices are down 49.2% despite a whole
slew of geopolitical events – from terror attacks in the West to Russo-Turkish quarrels – that
would have in the past raised the geopolitical risk premium.
3
Please see BCA Geopolitical Strategy Special Report, “Middle East: A Tale Of Red Herrings And Black Swans,” dated October 14,
2015, available at gps.bcaresearch.com.
4
Please see BCA Frontier Markets Strategy and Geopolitical Strategy Special Report, “Saudi Arabia: Caught In An Oil Slick,” dated
October 9, 2015, available at gps.bcaresearch.com.
5
Please see BCA Geopolitical Strategy and Commodity & Energy Strategy Special Report, “End Of An Era For Oil And The Middle
East,” dated April 8, 2015, available at gps.bcaresearch.com.
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2
The end of
OPEC as a
functioning
cartel will
continue to
dominate
the noise
coming from
deepening
conflict
between
Saudi Arabia
and Iran.
BCA RESEARCH INC.
GEOPOLITICAL STRATEGY - SPECIAL REPORT JANUARY 5, 2016
The first two trends are obvious tailwinds to
the geopolitical risk premium, which, given
today’s low oil prices, appears to have nowhere
to go but up. The end of OPEC as a functioning cartel, however, will continue dominate the
noise coming from deepening conflict between
Saudi Arabia and Iran. As long as Saudi Arabia
is unwilling to cut production and make room
for Iranian oil coming to the market in 2016,
the supply and demand dynamics will continue
to dominate oil prices.
CHART 2
Mn Bbl/
Day
98
96
…Into An Oversupplied Market
EIA ESTIMATE:
WORLD PRODUCTION (LS)
WORLD CONSUMPTION (LS)
IMPLIED STOCK CHANGE
AND BALANCE (RS)
Mn Bbl/
Day
3
2
94
92
1
90
With the physical oversupply in the market
0
standing at roughly 1.5 million bbl/d (Chart 2),
88
and with global growth still tepid, it will take
more than just a higher probability of conflict
86
-1
between Iran and Saudi Arabia to rattle energy
© BCA Research 2016
markets. It will take actual supply losses in the
2010
2012
2014
2016
context of an OPEC-less world to increase oil
SOURCE: BCA RESEARCH, EIA.
prices significantly. We therefore caution clients
from going long energy-related assets merely on account of the perceived spike in Saudi-Iranian
tensions. The most obvious consequences of today’s higher tensions are further price volatility
and a modest risk premium increase. BCA’s Commodity & Energy Strategy suggests going long a
December 2016 WTI $50/$55 call spread instead, as a low cost way to capture the higher probability of a right-tail risk event. Investors would pay a net premium of roughly $1.20/bbl, given
where the options were trading at publication.
Saudi Insecurity Explains (Nearly) Everything In The Middle East
Much ink has been spilled over the conflicts in Syria, Yemen, and the rise of the Islamic State.
These are all important developments but they are also symptoms of a much wider conflagration
in the Middle East at whose center is the deepening Saudi geopolitical insecurity. This insecurity
is a product of three factors:
FF
The American decision to significantly decrease its military footprint in the Middle East in
general (Chart 3) and Iraq in particular;
FF
Growing Iranian political and military influence in Iraq, as well as in Syria, Lebanon, Yemen,
and Bahrain;
FF
The broader détente between the West and Tehran, which seeks to reintegrate Iran into the
global economy and international community.
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GEOPOLITICAL STRATEGY - SPECIAL REPORT JANUARY 5, 2016
BCA RESEARCH INC.
The American
withdrawal
from Iraq in
December
2011 has left
a crucial piece
of Middle
Eastern real
estate in Irandominated
hands.
CHART 3
Th
CHART 4
As The U.S. Military Deleverages…
Th
FOREIGN DEPLOYMENT OF U.S. TROOPS:
MIDDLE EAST AND NORTH AFRICA
Bn
USD
80
250
250
200
200
150
150
100
100
50
…The Saudi Arabian Military Leverages
SAUDI ARABIA REAL MILITARY EXPENDITURE*
Bn
USD
80
60
60
40
40
20
20
50
© BCA Research 2016
© BCA Research 2016
05
10
15
SOURCE: THE HERITAGE FOUNDATION AND DEFENSE MANPOWER
DATA CENTER.
88 90 92 94 96 98 2000 02 04 06 08 10 12 14
* SHOWN IN CONSTANT 2011 $US.
SOURCE: THE SIPRI MILITARY EXPENDITURE DATABASE.
From the Saudi perspective, the American withdrawal from Iraq in December 2011 has left a crucial piece of Middle Eastern real estate in Iran-dominated hands. Following the 1991 Gulf War,
Saudi Arabia enjoyed the best of both worlds for two decades: a Sunni dominated, but weakened,
Iraq serving the role of an impregnable buffer between itself and the much more militarily capable
Iran. Since Iraq’s paradigm shift in the wake of American invasion, the buffer is not only gone but
replaced by a Shia-dominated, Iranian-influenced Iraqi state (albeit still relatively weak). Unsurprisingly, Saudi military spending has nearly doubled since the 2011 U.S. withdrawal, from $48.5USD
billion in 2011 to $80.8USD billion in 2015, revealing a deep concern by Riyadh that its northern
border has become nearly indefensible (Chart 4).
Iran’s influence in Iraq grew almost immediately following the American military withdrawal. Iraq’s
Shia Prime Minister, Nouri al-Maliki, wasted no time revealing his allegiance to Iran and sectarian
preferences. Baghdad issued an arrest warrant for the Sunni Vice President Tariq al-Hashimi literally
the day after the last American troops withdrew from the country, signaling to the Sunni establishment that compromise was not a priority. Persecution of the wider Sunni population soon followed,
with counter-insurgency operations in Sunni populated Al Anbar and Nineveh Governorates.
Baghdad’s heavy-handed political and military tactics produced an immediate reaction from the
Sunni population. Militant Sunni insurgent groups, with material support from unofficial (and
probably official) channels in Saudi Arabia and wider Gulf states, began to fight back. Violence
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GEOPOLITICAL STRATEGY - SPECIAL REPORT JANUARY 5, 2016
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Geopolitical
insecurity has
led Riyadh
to ditch its
traditionally
cautious
foreign policy
and take
matters into
its own hands.
escalated and soon melded with the emerging civil war in Syria, which by early 2013 had taken
on a sectarian cast as well. This led to the emergence of the Islamic State, which grew out of the
earlier Sunni insurgency against the U.S. in the Al Anbar governorate.
The military successes of the Islamic State in 2014 against the inexperienced and demoralized
Iraqi Army forced Baghdad to lean even more heavily on domestic Shia militias, and Iran, for survival. Islamic State militants reached the outskirts of Baghdad in September 2014 and were only
beaten back by a combination of hardline Shia militias and Iranian advisers and irregular troops.
From the Saudi perspective, this direct intervention by the Iranian military in Iraq was the final
straw. Most jarring to the Saudis was that the Americans acquiesced to the Iranian presence in Iraq
and even implicitly collaborated with Iran. In fact, the overt presence of Iranian military personnel
in Syria and Iraq drew no rebuke from the U.S. Some American officials even seemed to praise the
Iranian contribution to the global effort against the Islamic State. Meanwhile, the nuclear negotiations continued undisturbed, right down to their successful conclusion in July 2015.
Bottom Line: Saudi Arabia sees Iranian influence growing or at least holding firm throughout a
large swath of the Middle East. Most importantly, Shia Iran now has considerable influence in Iraq.
Geopolitical insecurity has led Riyadh to ditch its traditionally cautious foreign policy and take
matters into its own hands.
“Saudi Arabia Will Go It Alone”
Up until late 2014, Saudi strategy to counter Iranian influence in the region has leaned on three
traditional tactics, all of which relied in large part on influencing allies and proxies:
FF
Sunni militancy: Not only have Sunni militant groups failed to arrest Iranian influence in Syria
and Iraq, but also many militants have grown independent and evolved into a direct threat to
Saudi Arabia itself in a classic example of operational “blowback.” The Islamic State, which
received implicit support from Saudi Arabia in its early days of fighting Bashar al-Assad in Syria
and Shia-dominated Baghdad, has now turned against Saudi Arabia itself. Its agents have claimed
multiple mosque attacks in the Shia-populated Eastern Province in 2015, attacks which incite
sectarian violence in this critical Saudi province and the wider kingdom.
FF
K-Street: As with many special interests in the U.S. – from labor unions to the financial industry
– Saudi Arabia has relied on lobbying, Beltway consultants, and donations to curry favour in the
U.S. political system. But the U.S. détente with Iran has progressed despite this tactic. What
Saudi Arabia failed to appreciate was the emerging global phenomenon of multipolarity, and
particularly how the U.S. pivot to Asia would affect Washington’s policy toward the Middle East.6
6
Please see BCA Geopolitical Strategy Special Report, “Out Of The Vault: Explaining The U.S.-Iran Détente,” dated July 15, 2015,
available at gps.bcaresearch.com.
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GEOPOLITICAL STRATEGY - SPECIAL REPORT JANUARY 5, 2016
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Yemen serves
as a testing
ground for
new Saudi
hardware and
an attempt to
build esprit de
corps within
the Saudi
military and
among its
allies.
FF
Monetary support for allies: Saudi financial support for Egypt, Pakistan, and Sudan provided
an insurance policy amid growing Iranian influence. The money was spent with little return on
the investment, however, as Egypt and Pakistan have remained reticent to support the Saudi
military intervention in Yemen robustly.
Signs of Saudi frustration emerged as early as 2013. Protesting against the new U.S. policy in the
Middle East – which included refusing to bomb Bashar al-Assad after he crossed President Obama’s
“red line” of using chemical weapons against his opponents, continuing to negotiate a major deal
with Iran, and withholding extensive support for anti-Assad insurgents – Saudi Arabia refused to
join the UN Security Council in October 2013. In December 2013, Saudi Ambassador to the U.K.
and an influential royal family member, Mohammed Bin Nawaf Bin Abdulaziz Al Saud, penned a
concise and clear op-ed in The New York Times with a telling title: “Saudi Arabia Will Go It Alone.”7
Since then, Saudi Arabia has shifted gears. Its new tools in the foreign policy toolbox now include:
FF
Oil prices: The Saudi decision not only to refuse to coordinate on OPEC-wide production cuts
but actually to increase production as oil prices collapsed is largely geopolitical. Saudi Arabia
wants to apply economic pain to its main Shia-rivals, Iran and Iraq, and capture as much market share as it can. Iran and Iraq also have low lifting costs and are therefore the kingdom’s
major long-term competitors for market share in Asia, which is the main destination for most
crude oil from the Middle East and the biggest source of future demand growth. The perceived
desire to stifle U.S. shale oil production is overstated; Saudi strategy is primarily motivated by
geopolitical and commercial competition close to home.
FF
Direct military action: For the first time since the minimal 2011 intervention in Bahrain, which
was undertaken to quell a Shia uprising against the Sunni al-Khalifa monarchy, Saudi Arabia
has taken military matters into its own hands. Its military intervention in Yemen is as much a
trial run of the command and control capabilities of the Saudi military as it is an attempt to
dislodge Iranian-backed Houthi rebels. The massive increase in military spending, 180% over
the last decade, is no match for real experience. As such, Yemen serves as a testing ground
for new Saudi hardware and an attempt to build esprit de corps within the Saudi military and
among its allies. It is a “dress rehearsal” for an eventual intervention in the Sunni areas of Iraq.
FF
Sunni-Shia tensions: The timing of al-Nimr’s execution was not accidental. Saudi Arabia is trying to use sectarianism to strengthen domestic support for military action in Yemen, which has
proven unpopular. It was also probably intended to provoke an overreaction from Iran and Shias
around the Middle East. Saudi Arabia is looking to build ideological and sectarian cohesion
within its recently announced 34-state Sunni military coalition – a so-called “Sunni NATO.”
7
Please see Mohammed Bin Nawaf Bin Abdulaziz Al Saud, “Saudi Arabia Will Go It Alone,” dated December 17, 2013, available
at nytimes.com.
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GEOPOLITICAL STRATEGY - SPECIAL REPORT JANUARY 5, 2016
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The unifying
feature
of Saudi
Arabia’s new
military and
diplomatic
tactics is
unilateralism.
Bottom Line: The unifying feature of Saudi Arabia’s new military and diplomatic tactics is unilateralism: Riyadh is no longer depending on allies and proxies to defend Saudi interests but relying
on its own blood and treasure.
Constraints And Risks To Saudi Assertiveness
Saudi Arabia’s newfound assertiveness comes with costs, constraints, and execution risks.
The main constraint is material, although it can be overstated. Table 1 shows that, assuming an
average crude price of $50USD through the end of 2017, and assuming the government raises
its current nominal expenditure by 5% a year (which is not the government’s intention), the fiscal
deficit would balloon to 35% by the end of 2017. This would increase government debt levels to
44% of GDP and deplete the net foreign reserves of the Saudi Arabia Monetary Authority (SAMA)
to about $240USD billion at the end of 2017, from around $600 billion today.
These are considerable costs, but not beyond the kingdom’s financial resources. Even in our extreme
scenario of vast fiscal profligacy, Saudi Arabia would be left with ample room to increase debt issuance and tap into a quarter trillion USD of foreign currency reserves.
The much greater constraint on an activist foreign policy is overall domestic stability. First, Saudi
Arabia has begun to implement an austerity package that includes unpopular fuel subsidy cuts,
wage growth restraint, and an eventual implementation of a VAT. This is a complete policy reversal
from the $130USD billion USD stimulus package implemented amidst the Arab Spring instability
in 2011. The increase in social welfare payments, combined with ballooning defence costs, has
increased Saudi Arabia’s budget breakeven oil price from less than $40 in 2008 to $100 in 2015
(Chart 5).
TABLE 1
Saudi Arabia's Projected Debt Levels And Foreign Reserves
SAUDI ARABIA
2010
2011
2012
2013
2014
2015
2016E*
2017E*
FISCAL BALANCE (Bn USD)
$19
$75
$88
$43
-$25
-$126
-$184
-$217
AS A % OF GDP
4%
11%
12%
6%
-3%
-20%
-30%
-35%
-$63
-$92
-$109
-10%
-15%
-18%
11%
26%
44%
-$63
-$92
-$109
(1) FINANCING 50% OF DEFICIT THROUGH
NEW BORROWING (Bn USD)
AS A % OF GDP
GOVERNMENT DEBT LEVEL AS A % OF GDP
5%
4%
2%
2%
(2) FINANCING 50% OF DEFICIT THROUGH
WITHDRAWAL FROM SAMA (Bn USD)
SAMA'S NET FOREIGN RESERVES (Bn USD)
AVERAGE OIL EXPORT PRICE (BRENT - USD/Bbl)
$440
$535
$648
$717
$724
$596
$425
$239
$107
$110
$106
$96
$59
$50
$50
NOTE: THE ANALYSIS ASSUMES THE FOLLOWING FOR 2016 AND 2017: (1) OIL PRICE OF $50/BARREL (2) AVERAGE ANNUAL GROWTH RATE OF
5% IN GOVERNMENT EXPENDITURE (3) FINANCIAL ACCOUNT DEFICIT OF $60 BILLION PER ANNUM. IT ALSO ASSUMES HALF OF THE
FISCAL DEFICIT WILL BE FINANCED VIA GOVERNMENT BORROWING AND THE OTHER HALF BY WITHDRAWAL OF GOVERNMENT DEPOSITS
WITH SAMA.
* BCA PROJECTIONS.
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7
The fact is that
Saudi Arabia
is no stranger
to palace
coups.
BCA RESEARCH INC.
GEOPOLITICAL STRATEGY - SPECIAL REPORT JANUARY 5, 2016
In our view, the austerity cuts will have to go,
or will have to be phased in much slower than
policymakers expected. That is why we assume
that the government will fail to implement any
deficit cuts in our sensitivity analysis and why
the costs of an interventionist foreign policy
will continue to be high.
CHART 5
USD/
120
Bbl
Saudi’s Fiscal Breakeven
Oil Price Has Doubled
SAUDI ARABIA: FISCAL BREAKEVEN OIL PRICE
100
80
The much larger problem is that austerity
breaks the Saudi social contract, which for
decades has meant that generous social welfare
60
spending obviates the need for political reform.
A toxic mix of high youth population, high levels
40
of tertiary education, a lack of job opportunities for university graduates, deep penetration
of social media, and a shortage of channels for
20
political participation represents a constant
structural political risk to Saudi Arabia. Most
© BCA Research 2016
citizens understand that the austerity measures
0
2008 2009 2010 2011 2012 2013 2014 2015
are a direct consequence of the unpopular miliSOURCE: IMF MIDDLE EAST AND NORTH AFRICA REGIONAL ECONOMIC
OUTLOOK 2012, 2015.
tary operations in Yemen, and now potentially
wider assertiveness in the region. The benefits
of the trade-off are unclear to the wider population, which explains why policymakers are trying to
rely on the Shia-Sunni dynamic to defend their expensive, activist foreign policy.
In addition, the ruling Sudairi branch of the royal family has taken control of almost all levers of
power, increasing discontent within the large Saud royal dynasty.8 The new King Salman has appointed his nephew Muhammad bin Nayef as Crown Prince. His son, Mohammad bin Salman Al
Saud, has been appointed as Deputy Crown Prince (and Defence Minister), ahead of over 100 other
eligible princes, most of them twice Mohammad bin Salman’s age.
Mohammad bin Salman is clearly being groomed to take over from his father and is often referred
to as the de facto ruler of the country. His youth and rapid rise to power are highly unusual and
have irked members of the royal family and the wider public. The consensus-building style of monarchy practiced in the Arabian Peninsula is one where the king is considered “first among equals,”
rather than an absolute monarch. As such, King Salman’s promotion of his own Sudairi branch will
8
The Sudairi branch of the Saud dynasty refers to the issue of Saudi Arabia’s founder Abdulaziz Ibn Saud with Hassa bint Ahmed
Al Sudairi, one of Ibn Saud’s wives and a member of the powerful Al Sudairis clan. The union produced seven sons, the largest
faction out of the 45 sons that Ibn Saud fathered. As the largest grouping, the sons – often referred to as the ‘Sudairi Seven’ –
were able to consolidate power and unite against other brothers. In addition to the current King Salman, the other member of the
Sudairi faction who became a King was Fahd, ruling from 1982 to 2005.
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GEOPOLITICAL STRATEGY - SPECIAL REPORT JANUARY 5, 2016
BCA RESEARCH INC.
Eastern
Province
is home to
almost all
Saudi oil
production
and
transportation
facilities.
grate on his rivals. In addition, age and experience carry a lot of weight in the traditional Bedouin
societies of Arabia, which makes Mohammad bin Salman’s appointment as the second in line to
the throne all the more puzzling.
The fact is that Saudi Arabia is no stranger to palace coups. In 1964, King Saud was forced to
abdicate, ushering in the reign of his brother King Faisal. The three main reasons for regime change
were Saud’s profligate spending, lack of consensus-building politics, and foreign policy adventurism. Given the present context, this is an ominous precedent.
Another obvious risk is that Saudi use of the Shia-Sunni rift will complicate ongoing sectarian
conflict in Syria and Iraq and potentially spark new conflicts in Bahrain and its own Eastern Province. The Eastern Province is home to almost all Saudi oil production and transportation facilities
and its population is believed to be approximately 30-50% Shia (Map 1).9 Bahrain’s population is
majority Shia but ruled by a Sunni al-Khalifa dynasty close to Saudi Arabia. The island kingdom’s
oil production is controlled by the Saudis, but Bahrain is strategically located and the home of the
U.S. Fifth Fleet. Tensions in either region could deepen the Saudi-Iranian rift in a sensitive part
of the Persian Gulf.
MAP 1
Saudi Arabia’s Eastern Province Is A Crucial Piece Of Real Estate
EASTERN
PROVINCE
SOURCE: U.S. ENERGY INFORMATION ADMINISTRATION.
9
Due to a lack of census data, there is no authoritative information as to the proportion of Shia population in Saudi Arabia.
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GEOPOLITICAL STRATEGY - SPECIAL REPORT JANUARY 5, 2016
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Saudi
diplomatic
and military
moves, as well
as strategic
logic, suggest
that Riyadh
is concerned
with its
northern
flank and
may intervene
militarily in
Iraq.
One risk we believe is overstated is overt Iranian intervention in Saudi Arabia and Bahrain. Certainly
Iran may try to connect with proxies and supply them with material support. However, Iran has no
reason to give the international community, especially the U.S., an excuse to break off the nuclear
deal and broader rapprochement. It is expected to increase oil production by around 700,000
bbl/d by the end of the year and to benefit from a general opening of its economy. Furthermore, its
strategy in Syria and Iraq is currently paying off. It would risk too much by intervening directly on
behalf of Shias in Eastern Province and Bahrain. We would therefore expect Tehran to incite tensions in these areas from a distance and consolidate its considerable gains in the rest of the region.
This should limit the direct impact of sectarian tensions on production and transportation facilities.
Bottom Line: The main constraints to the newfound Saudi assertiveness are not material but political.
Saudi Arabia has sufficient resources, at least on paper, to pursue both market share and military
adventurism. However, political support for this strategy will wear thin if it requires the population
to sacrifice too much of its wellbeing. To reduce this domestic political risk, Saudi policymakers
may find it convenient to export Sunni-Shia tensions to the wider region.
Investment Conclusions
The Saudi-Iranian conflict is deepening and potentially breaking into the open. The timing of the
provocative Saudi execution suggests that Riyadh wants to escalate tensions with Iran in particular
and Shias more broadly.
In a recent report, Middle East: A Tale Of Red Herrings And Black Swans, we told our clients that
a simple way to cut through the cacophony of reporting on the region is to ask three questions
whenever new tensions or conflict crop up:
FF
Oil supply: Does the conflict or event impact oil supply or vital transportation routes directly?
FF
Geography: Is the event or conflict occurring in a geography that is of existential significance
to one of the regional or global players?
FF
Sectarian contagion: Will the event exacerbate sectarian conflict between Sunnis and Shias?
The recent bout of Saudi-Iranian tensions passes all three tests. It is likely to exacerbate tensions in
Eastern Province and Bahrain. In addition, Saudi diplomatic and military moves, as well as strategic
logic, suggest that Riyadh is concerned with its northern flank and may intervene militarily in Iraq
in the near term. This could be especially tempting given that the Islamic State has lost 20% of the
territory it controls in 2015, including the provincial capital of Sunni populated Al Anbar Governorate. While Saudi policymakers have no love for the Islamic State, its defeat means that Iraqi forces
allied with Iran may sweep deep into Al Anbar and extend their sway all the way to the Iraqi border.
But deeper Saudi-Iranian tensions also mean that OPEC will remain dysfunctional. Saudi policy of
keeping oil production high will therefore remain in place. Without OPEC to balance the market, fundamental supply and demand dynamics will continue to weigh on oil prices. Short of a significant shock
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10
GEOPOLITICAL STRATEGY - SPECIAL REPORT JANUARY 5, 2016
BCA RESEARCH INC.
Investors
could go long
a $50/$55
WTI call
spread using
the December
2016
Americanstyle WTI
options.
to production that clears today’s physical oversupply, OPEC’s irrelevance will continue to drown out
the sound of rising geopolitical risk, at least until oil fundamentals rebalance near the end of the year.
BCA’s Commodity & Energy Strategy expects this rebalance to happen by Q3 2016, due to the loss
of high-cost global production. At that point, prices will drift toward a central tendency of $50/
bbl from the end of 2016 to the end of 2018. Geopolitical risks will then have a greater impact
on spot prices, as any loss of supply will have a greater impact in a balanced market than it has in
today’s oversupplied one.
Going long Brent December 2016 contract may make intuitive sense given the rebalancing story
and the increasing geopolitical risk premium. However, the market remains unbalanced and such
a position could be stopped out several times between now and then.
BCA’s Commodity & Energy Strategy Managing Editor Bob Ryan instead suggests an alternative
strategy to articulate the nuanced geopolitical and fundamental environment. Investors could go
long a $50/$55 WTI call spread using the December 2016 American-style WTI options. These options have better price discovery, and, with U.S. exports now allowed, any big price event will be
met almost immediately from U.S. shale producers first. The maximum loss on such a position is
the net premium paid to open and carry it (roughly $1.15 to $1.20/bbl at the time of publication),
while the maximum gain would be $5/bbl minus the net premium.
Given the geopolitical environment – which combines the context of an OPEC-less world with the
increasing probability of a tail-risk event due to Saudi-Iranian tensions – going long the $50/$55
December 2016 WTI call spread is an attractive way to get low-risk exposure to potential geopolitical risk without the risk of prices collapsing in the interim.
The market is currently obsessing about downside risk to oil prices, and for good reason. But, we
believe, in its downside obsession, the market is therefore mispricing a potential right-tail event,
such as a Saudi intervention in Iraq or social unrest in Eastern Province and Bahrain. By putting
on this call-spread position, we are willing to pay a little over a dollar (cost of the spread between
the two calls) for the chance to net ~$3.80/bbl, which would be the payout if geopolitical risk becomes manifest. Furthermore, if Bob’s fundamental view is correct and the market is rebalanced
by year-end, prices could trade closer to $55/bbl on fundamentals alone.
We recommend that our clients read more about Bob’s take on how to play volatility in the oil
markets in his publication, which will publish in the BCA Commodity & Energy Strategy tomorrow.
Marko Papic, Managing Editor
[email protected]
Robert P. Ryan, Managing Editor
[email protected]
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12